We use cookies to customise content for your subscription and for analytics.If you continue to browse Lexology, we will assume that you are happy to receive all our cookies. For further information please read our Cookie Policy.

On September 3, 2014, the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the Farm Credit Administration and the Federal Housing Finance Agency (collectively, prudential regulators) proposed new rules concerning margin and capital requirements for certain entities as required by Title VII of the Dodd-Frank Act. Comments regarding the proposed rules (prudential regulators’ proposed rule) must be submitted to the prudential regulators on or before November 24, 2014.

On September 23, 2014, the Commodity Futures Trading Commission (CFTC) proposed new rules concerning margin requirements for Swap Dealers and Major Swap Participants on all non-cleared swaps (CFTC proposed rule). The CFTC proposed rule closely follows the prudential regulators’ proposed rule, with some exceptions as discussed below. Comments regarding the CFTC proposed rule must be submitted to the CFTC on or before December 2, 2014.

The prudential regulators’ proposed rule and the CFTC proposed rule, together referred to as the “regulators’ proposed rules,” may affect the ability of banks, insurance companies, hedge funds and mutual funds, asset managers, pension plans and securitization vehicles, among other types of entities, to hedge their assets and liabilities and may increase the costs of such hedging activities.

Background

Initial margin and variation margin. The regulators’ proposed rules would impose requirements relating to initial margin and variation margin. Initial margin is collateral that is posted at the outset of a transaction, typically in a fixed amount, and is independent of the mark-to-market valuations and the parties’ positions under the underlying transaction. Variation margin, on the other hand, consists of collateral posted or collected to cover the parties’ mark- to-market exposure under the underlying transaction. If a party’s position improves relative to the previous valuation, that party may be entitled to receive collateral from its counterparty or to have some of its posted collateral returned by its counterparty.

Prudential regulators’ proposed rule. The prudential regulators originally proposed rules in 2011 to implement the Dodd-Frank Act’s margin and capital requirements. In 2013, the Basel Committee on Banking Supervision (BCBS) and the Board of International Organization of Securities Commissions (IOSCO) finalized a framework for margin requirements on non-cleared swaps with the goal of creating an international standard. In many respects, the prudential regulators’ proposed rule is consistent with the BCBS/IOSCO international framework. Significantly, however, as discussed below, in contrast to the prudential regulators’ 2011 proposal, commercial end users are exempted from mandatory margin requirements for uncleared swaps under the prudential regulators’ proposed rule.

The prudential regulators’ proposed margin requirements would apply to each entity listed as prudentially regulated under the Commodity Exchange Act (CEA) if that entity (1) is a swap dealer (SD), major swap participant (MSP), security-based swap dealer or major security-based swap participant (prudentially regulated swap entities) and (2) enters into a non-cleared swap. In addition, if adopted by the prudential regulators, the requirements would apply to all of a prudentially regulated swap entity’s swap and security-based swap activities without regard to whether the entity has registered as both a swap entity (a swap dealer or major swap participant) and a security-based swap entity (a security-based swap participant or major security-based swap participant).

CFTC proposed rule. Like the prudential regulators, the CFTC originally proposed rules in 2011 to implement the Dodd-Frank Act’s margin requirements. As with the prudential regulators’ proposed rule, the CFTC proposed rule is, in many respects, consistent with the BCBS/IOSCO international framework.

The CFTC’s proposed margin requirements, on the other hand, would apply only to those SDs and MSPs for which there is no prudential regulator (CFTC swap entities). CFTC swap entities include, among others, nonbank subsidiaries of bank holding companies, as well as certain foreign SDs and MSPs. CFTC swap entities and prudentially regulated swap entities are referred to collectively in this SEC Update as “covered swap entities.”

Margin requirements

Counterparty identifications

The regulators’ proposed rules distinguish among four separate types of swap counterparties:

•Sapentities

•ledusshaatlasex”seedlw

•Fledussotalase

•Othercounteprties,includingnonfiaciald,inisduetb

The regulators’ proposed rules distinguish between financial end users that have material swaps exposure and financial end users that do not have material swaps exposure. The regulators’ proposed rules define “material swaps exposure” to mean that the entity and its affiliates have an average daily aggregate notional amount of non-cleared swaps, non-cleared security-based swaps, foreign exchange forwards and foreign exchange swaps with all counterparties for June, July and August of the previous year that exceeds $3 billion, where such amount is calculated only for business days. This is significantly lower than the €8 billion threshold contained in the BCBS/IOSCO international framework. The sub-categorization of financial end users in the regulators’ proposed rules based on purely quantitative factors contrasts with the combined qualitative and quantitative approach of the prudential regulators’ 2011 proposal, which divided financial end users into “high-risk financial end users” and “low- risk financial end users,” and the CFTC’s 2011 proposal, which did not sub-categorize “financial entities” except for limited purposes related to initial margin and variation margin thresholds.

Definition of financial end user

The initial margin and variation margin requirements under the regulators’ proposed rules for financial end users differ from those for other types of counterparties. Under the regulators’ proposed rules, a “financial end user” is generally defined to mean any counterparty that is not a swap entity and that, among other types of entities, is a bank holding company or an affiliate thereof, a depository institution, a foreign bank, a state or federal credit union, a securities holding company, a broker or dealer, an investment adviser or a commodity pool. The regulators’ proposed rules exempt from the definition of “financial end user” sovereign entities, multilateral development banks, The Bank for International Settlements and entities that qualify for the captive-finance company and inter-affiliate exceptions from mandatory clearing. A list of the types of entities that would qualify as financial end users under the regulators’ proposed rules is presented in Appendix A to this SEC Update.

Initial margin

The prudential regulators and the CFTC have proposed very similar margin requirements. As a general matter, where a covered swap entity transacts with another swap entity (without regard to whether the other swap entity meets the definition of a “covered swap entity” under the regulators’ proposed rules), the covered swap entity must collect at least the amount of initial margin required under the regulators’ proposed rules. If both parties are covered swap entities, then both must collect and post a minimum amount of initial margin when transacting with each other. The initial margin collection amount would be calculated pursuant to a table in each set of proposed rules or pursuant to an internal risk management model that has been approved by the relevant prudential regulator or the CFTC. Under the regulators’ proposed rules, among other requirements, such a model must calculate an amount of initial margin that is equal to the potential future exposure of the uncleared swap, with potential future exposure being an estimate of the one-tailed 99% confidence interval for an increase in the value of the uncleared swap or netting set of uncleared swaps due to an instantaneous price shock that is equivalent to a movement in all material underlying risk factors, including prices, rates and spreads, over a holding period equal to the shorter of ten business days or the maturity of the uncleared swap.

A covered swap entity transacting with a financial end user with a material swaps exposure must collect at least the amount of initial margin required by the regulators’ proposed rules and must post at least the amount of initial margin that the covered swap entity would be required by the regulators’ proposed rules to collect if the covered swap entity were in the place of the counterparty. Furthermore, a covered swap entity must post or collect initial margin on at least a daily basis in response to changes in the required initial margin amounts stemming from changes in portfolio composition or any other factors that result in a change in the required initial margin amounts.

A covered swap entity transacting with a financial end user without a material swaps exposure does not need to collect or post initial margin, although, as discussed below, such a transaction is subject to variation margin requirements. Even though there is no initial margin requirement for these transactions, a covered swap entity may collect and post initial margin as it determines to be appropriate.

$65 million, below which the covered swap entity need not collect or post initial margin from or to swap entities and financial end users with material swaps exposures. The proposed initial margin threshold of $65 million would be

applied on a consolidated entity level and, therefore, would apply across all non-cleared swaps between a covered

swap entity and its affiliates and the counterparty and its affiliates.

Additionally, in order to reduce transaction costs, the prudential regulators and the CFTC propose a “minimum transfer amount” of $650,000. Initial and variation margin payments would not be required if the payment were below that amount. This amount is consistent with international standards.

Variation margin

The regulators’ proposed rules generally require a covered swap entity to collect or post variation margin on swaps with a swap entity or a financial end user (without regard to whether the financial end user has a material swaps exposure) in an amount that is at least equal to the increase or decrease in the value of the swap since the counterparties’ previous exchange of variation margin. The regulators’ proposed rules would not permit a covered swap entity to adopt a threshold amount below which it need not collect or post variation margin on swaps with swap entities and financial end users. Covered swap entities would be required to collect or post variation margin with swap entities and financial end users on at least a daily basis. The responsibility to collect and pay variation margin would rest with the covered swap entity.

Although the regulators’ proposed rules require that covered swap entities collect variation margin from all financial end users (without regard to whether the financial end users have material swaps exposures), the regulators’ proposed rules do not impose a minimum initial margin requirement on transactions with those financial end users that are not swap entities and that do not have a material swaps exposure.

Under the regulators’ proposed rules, covered swap entities are not required to collect or post initial or variation margin from or to any individual counterparty unless and until the required cumulative amount of initial and variation margin is greater than $650,000. This represents an increase from the $100,000 minimum transfer amount proposed separately by the prudential regulators and the CFTC in 2011.

Under the CFTC proposed rule, each CFTC swap entity would be required to calculate variation margin for itself and for each covered counterparty using a methodology and inputs that, to the maximum extent practicable and in accordance with existing regulations, rely on recently executed transactions, valuations provided by independent third parties or other objective criteria. In addition, each CFTC swap entity would be required to have in place alternative methods for determining the value of an uncleared swap in the event of the unavailability or other failure of any input required to value a swap.

Additionally, under the CFTC proposed rule, each CFTC swap entity would be required to create and maintain documentation setting forth the variation margin methodology with sufficient specificity to allow the counterparty, the CFTC and any applicable prudential regulator to calculate a reasonable approximation of the margin requirement independently. Each CFTC swap entity also would be required to evaluate the reliability of its data sources at least annually, and make adjustments, as appropriate. The proposal would permit the CFTC to require a CFTC swap entity to provide further data or analysis concerning the methodology or a data source.

Margin requirements for counterparties such as commercial end users

Under the regulators’ proposed rules, in line with the final BCBS/IOSCO international framework, a covered swap entity has discretion to determine whether to collect margin from counterparties that are not swap entities or financial end users, such as nonfinancial or commercial end users that generally engage in swaps to hedge commercial risk, sovereign entities and multilateral developments banks. In other words, a covered swap entity is not required to collect initial and variation margin from “other counterparties” (as defined in the prudential regulators’ proposed rule) or “non-financial end users” (as defined in the CFTC proposed rule). The regulators’ proposed rules keep in place the current practice of collecting initial or variation margin at such times and in such forms and amounts (if any) as the covered swap entity determines in its overall credit risk management of the swap entity’s exposure to the customer.

In a slight deviation from the prudential regulators’ proposed rule, for risk management purposes, the CFTC proposes to require each CFTC swap entity to calculate hypothetical initial and variation margin amounts each day for positions held by nonfinancial entities that have material swaps exposure to the CFTC swap entity. The CFTC swap entity thus must calculate what the margin amounts would be if the counterparty were another SD, MSP or financial end user with material swaps exposure and compare them to any actual margin requirements for the positions.

Counterparty Category

Table A – Summary of margin requirements for uncleared swaps

Swap entity‡ Financial end users Other counterparties‡‡‡

Margin

Material swaps exposure ‡‡

No material swaps exposure‡‡‡

Initial Margin Required to collect and post

Variation Margin Required to collect and post

Required to collect and post

Required to collect and post

Collect and post as determined to be appropriate by the covered swap entity Required to collect and post

Collect and post as determined to be appropriate by the covered swap entity Collect and post as determined to be appropriate by the covered swap entity

‡ Swap dealers, major swap participants, security-based swap dealers (for which there is a prudential regulator) and security-based major swap participants (for which there is a prudential regulator).

‡‡ Material swaps exposure is defined to mean that the entity and its affiliates have an average daily aggregate

notional amount of non-cleared swaps, non-cleared security-based swaps, foreign exchange forwards and foreign exchange swaps with all counterparties for June, July and August of the previous year that exceeds $3 billion, where such amount is calculated only for business days.

‡‡‡ This category includes nonfinancial end users, sovereign entities and multilateral development banks.

Eligible collateral

The regulators’ proposed rules limit the types of collateral that are eligible to be used to satisfy both the initial and variation margin requirements. Eligible collateral is generally limited to high-quality, liquid assets that are expected to remain liquid and retain their value, after accounting for an appropriate risk-based ‘‘haircut,’’ during a severe economic downturn. Eligible collateral for variation margin is limited to cash.

There are no valuation haircuts for variation margin, because eligible collateral for variation margin is limited to cash.

Equities included in S&P 1500 Composite or related index but not S&P 500 or related index

N/A Yes No 25%

Gold N/A Yes No 15%

Segregation of initial margin amount and prohibition on reuse of initial margin amount

Compared to the BCBS/IOSCO final international framework, the regulators’ proposed rules contain more stringent requirements with respect to segregation and reuse of initial margin amounts.

Under the regulators’ proposed rules, a covered swap entity must require that any collateral (other than variation margin) that it posts to its counterparty (even collateral in excess of any required by the regulators’ proposed rules) be segregated at one or more custodians that are not affiliates of the covered swap entity or its counterparty (third- party custodian). Similarly, a covered swap entity must place with a third-party custodian the initial margin it collects from a swap entity or a financial end user with material swaps exposure.

Additionally, under the regulators’ proposed rules, the third-party custodian would be prohibited, by agreement, from certain actions with respect to any of the funds or other property it holds as initial margin. Prohibited activities would include rehypothecating, repledging, reusing or otherwise transferring any of the funds or other property the third- party custodian holds and, with respect to initial margin required to be posted or collected, substituting or reinvesting any funds or other property in any asset that would not qualify as eligible collateral under the regulators’ proposed rules.

Funds or other property held by a third-party custodian but not required to be posted or collected under the regulators’ proposed rules are not subject to any of these restrictions on collateral substitution or reinvestment.

Cross-border application of prudential regulators’ proposed rule

Under the prudential regulators’ proposed rule, foreign swaps of foreign prudentially regulated swap entities would not be subject to the margin requirements of the prudential regulators’ proposed rule. Further, certain prudentially regulated swap entities that are operating in a foreign jurisdiction and covered swap entities that are organized as

branches of foreign banks may choose to abide by the swap margin requirements of the foreign jurisdiction if the prudential regulators determine that the foreign regulator’s swap margin requirements are comparable to those of the

prudential regulators’ proposed rule.

In a deviation from the prudential regulators’ proposed rule, the CFTC announced that it is considering three alternative approaches to applying margin requirements to CFTC swap entities:

•AtransactionlvelapprochthatisconsistentheFTsdrieduly0iep

•eilu’aprhddb

•nlhll

Under the guidance approach, the proposed margin requirements would apply to each U.S. SD or MSP (other than a foreign branch of a U.S. bank that is a SD or MSP) for all of its uncleared swaps (as applicable), irrespective of whether its counterparty is a U.S. person, without the availability of substituted compliance. The proposed margin requirements, however, would apply to a non-U.S. SD or MSP (regardless of whether it is a “guaranteed affiliate” or an “affiliate conduit” of a U.S. person) only with respect to its uncleared swaps with a U.S. person counterparty (including a foreign branch of a U.S. bank that is a SD or MSP) and a non-U.S. counterparty that is guaranteed by, or an affiliate conduit of, a U.S. person.

Under the guidance approach, where the counterparty is a guaranteed affiliate or an affiliate conduit of a U.S. person, the CFTC would allow substituted compliance (i.e., the non-U.S. SD or MSP would be permitted to comply with the margin requirements of its home regulator if the CFTC determines that the requirements are comparable to the CFTC’s margin requirements) for foreign branches of U.S. SDs and MSPs as well as non-U.S. SDs and MSPs.

Table C – Proposed cross-border guidance approach

U.S. Person (other than Foreign Branch of U.S. Bank that is a Swap Dealer or MSP)

Foreign Branch of U.S. Bank that is a Swap Dealer or MSP

Non-U.S. Person Guaranteed by, or Affiliate Conduit of, a U.S. Person

Non-U.S. Person Not Guaranteed by, and Not an Affiliate Conduit of, a U.S. Person

U.S. Swap Dealer or MSP (including an affiliate of a non-U.S. person)

Apply Apply Apply Apply

U.S. Person (other than Foreign Branch of U.S. Bank that is a Swap Dealer or MSP)

Foreign Branch of U.S. Bank that is a Swap Dealer or MSP

Non-U.S. Person Guaranteed by, or Affiliate Conduit of, a U.S. Person

Non-U.S. Person Not Guaranteed by, and Not an Affiliate Conduit of, a U.S. Person

Foreign Branch of

Bank that is a Swap Dealer or MSP

Apply Substituted Compliance

Substituted Compliance

Substituted Compliance

Non-U.S. Swap Dealer or MSP (including an affiliate of a U.S. person)

Apply Substituted Compliance

Substituted Compliance

Do Not Apply

Under the entity-level approach, the CFTC would apply its cross-border rules on margin on a firm-wide level, irrespective of whether the counterparty is a U.S. person.

In recognition of international comity, the CFTC is considering, where appropriate, to allow SDs and MSPs to satisfy the margin requirements by complying with a comparable regime in the relevant foreign jurisdiction, as described in the table below.

Non-U.S. person not registered as an SD/MSP and not guaranteed by a U.S. person

Substituted compliance (All)

Compliance dates

The compliance date for collection of variation margin is December 1, 2015. The regulators’ proposed rules set forth staggered compliance dates for collection of initial margin depending on the covered swap entity’s and its counterparty’s combined average daily aggregate notional amount of covered swaps for June, July and August of a particular year, starting from December 1, 2015.

Table E - Initial margin compliance dates

Compliance Date

Initial Margin Requirements

December 1, 2015

Initial margin where both the covered swap entity

combined with its affiliates and the counterparty combined with its affiliates have an average daily aggregate notional amount of covered swaps for June, July and August of 2015 that exceeds $4 trillion.

December 1, 2016

Initial margin where both the covered swap entity

combined with its affiliates and the counterparty combined with its affiliates have an average daily aggregate notional amount of covered swaps for June, July and August of 2016 that exceeds $3 trillion.

December 1, 2017

Initial margin where both the covered swap entity

combined with its affiliates and the counterparty combined with its affiliates have an average daily aggregate notional amount of covered swaps for June, July and August of 2017 that exceeds $2 trillion.

December 1, 2018

Initial margin where both the covered swap entity

combined with its affiliates and the counterparty combined with its affiliates have an average daily aggregate notional amount of covered swaps for June, July and August of 2018 that exceeds $1 trillion.

December 1, 2019

Initial margin for any other covered swap entity with

respect to covered swaps with any other counterparty.

APPENDIX A

The regulators’ proposed rules define a financial end user to mean any counterparty that is not a swap entity and that is:

A bank holding company or an affiliate thereof; a savings and loan holding company; or a nonbank financial institution supervised by the Board of Governors of the Federal Reserve System under Title I of the Dodd-Frank Wall Street Reform and Consumer Protection Act;

A depository institution; a foreign bank; a Federal credit union or State credit union as defined in section 2 of the Federal Credit Union Act; an institution that functions solely in a trust or fiduciary capacity as described in section 2(c)(2)(D) of the Bank Holding Company Act; an industrial loan company, an industrial bank, or other similar institution described in section 2(c)(2)(H) of the Bank Holding Company Act;

A money services business, including a check casher; money transmitter; currency dealer or exchange; or money order or traveler’s check issuer;

A regulated entity as defined in section 1303(20) of the Federal Housing Enterprises Financial Safety and Soundness Act of 1992 and any entity for which the Federal Housing Finance Agency or its successor is the primary federal regulator;

Any institution chartered and regulated by the Farm Credit Administration in accordance with the Farm Credit Act of 1971;

A securities holding company; a broker or dealer; an investment adviser as defined in section 202(a) of the Investment Advisers Act of 1940; an investment company registered with the U.S. Securities and Exchange Commission under the Investment Company Act of 1940; or a company that has elected to be regulated as a business development company pursuant to section 54(a) of the Investment Company Act of 1940;

A private fund as defined in section 202(a) of the Investment Advisers Act of 1940; an entity that would be an investment company under section 3 of the Investment Company Act of 1940 but for section 3(c)(5)(C) or an entity that is deemed not to be an investment company under section 3 of the Investment Company Act of 1940 pursuant to Rule 3a-7 of the U.S. Securities and Exchange Commission;

A commodity pool, a commodity pool operator, or a commodity trading advisor as defined, respectively, in section 1a(10), 1a(11), and 1a(12) of the Commodity Exchange Act; or a futures commission merchant;

An employee benefit plan as defined in paragraphs (3) and (32) of section 3 of the Employee Retirement Income Security Act of 1974;

An entity that is organized as an insurance company, primarily engaged in writing insurance or reinsuring risks underwritten by insurance companies, or is subject to supervision as such by a State insurance regulator or foreign insurance regulator;

An entity that is, or holds itself out as being, an entity or arrangement that raises money from investors primarily for the purpose of investing in loans, securities, swaps, funds or other assets for resale or other disposition or otherwise trading in loans, securities, swaps, funds or other assets;

A non-U.S. entity that would be a financial end user if it were organized under the laws of the United States or any State thereof; or

Any other entity that the prudential regulators or the CFTC has determined should be treated as a financial end user.

This SEC Update is a summary for guidance only and should not be relied on as legal advice in relation to a particular transaction or situation. If you have any questions, please contact your usual contact at Hogan Lovells or any of the lawyers listed in this Update

Compare jurisdictions:Patents

”Lexology is a useful and informative tool. I keep copies of relevant articles and often forward them to colleagues. Although I do not know all of the authors/firms, by reading their articles I do gain an understanding of their appreciation of a topic, and should the need arise I would not hesitate to contact them on those topics.”